Thursday, August 15, 2013

U.S. industrial production was a bit disappointing in July, and from the chart above we can see that production growth has been slowing for the past few months. But that slowing is more than offset, from a global perspective, by a surge in German industrial production and some gradual improvement in Eurozone industrial production. The Eurozone appears to be coming out of its 2-year recession, and that is good news for Europeans and for the world.

A few days ago you wrote: "The Fed will stop buying and eventually—in a year or so—start selling bonds as the economic fundamentals improve. When they finally do begin to reverse QE, they will be selling bonds at higher interest rates than we have today (e.g., 10-yr Treasury yields of 4% or so) when the demand for them will be stronger."

Question, when the Fed does sell their QE acquired Treasury bonds and MBS, they will be selling them at a substantial loss. I am wondering how big that loss could be - in the hundreds of billions of dollars I would guess. They will spread the loss over years but still.

The Fed has several options to avoid selling bonds at a loss. To begin with, the Fed is earning a healthy spread on its bond holdings: it receives an interest rate of about 2.5% on its holdings of $3.4 trillion of bonds—$85 billion per year—while paying 0.25% on $2.2 trillion of reserves—$5.5 billion per year. That leaves them with net cash earnings of about $80 billion per year, and that can cover lots of losses. Second, the Fed can stop reinvesting principal repayments; assuming an average life of 7 years on its $1.25 trillion of MBS, that could effectively reduce its holdings by, say, $150 billion per year with no losses. Third, the Fed can control the pace of its sales of bonds by increasing the interest it pays on reserves—the higher the interest rate the tighter the policy, without the need to sell bonds.

As for the losses, I'm going to guess that the Fed's bond portfolio has a duration of 5 years. That means that every 1 percentage point increase in bond yields results in a 5% loss on its bond holdings. So it may have lost only about $175 billion with the current rise in rates, and that can be made up with two years' worth of cash flow.

Presumably the Fed is constantly running simulations of how all these factors can play out. It is hard to believe they have gotten themselves into a corner with no exit strategy.

Scott - I discovered your blog during the depths of the market crisis in 2009. I wanted to let you know that I believe you and Riverfront Investment Group have provided the most sound and reasoned analysis that I've seen. Thank you for keeping me in the game when there were many times I felt like jumping!

I do have a question for you with regards to Fed tapering on the horizon. There is a school of thought that profits have been propped up because companies have been borrowing at very low rates, therefore, when the Fed pulls the plug and rates go higher, profits will decline, and with it the stock market. Is there any data to support this - in other words, are companies significantly benefiting from lower rates?

Also, do you believe Brett Arends's theory on "discount rates" holds any water:

Scott Grannis said....." It is hard to believe they have gotten themselves into a corner with no exit strategy."

It is not hard to believe if you understand the way the world works. No exit strategy is exactly the corner Bernanke has painted himself with his monetary response to the 2008 crisis based on his academic misunderstanding of the cause of the GD. The GD was caused by fiscal error, not monetary. Bernanke operates in the wrong demand-side model; so all his assumptions lead to inaccuracy.

Bernanke's speech, A Century of U.S. Central Banking: Goals, Frameworks, Accountability, sums up nicely his errant views. If you start with an assumption based on an errant model derived from a misunderstanding of an historic crisis and then quadruple down the errant lessons (mis)learned on our current crisis, you end up exactly with no exit strategy.